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Risk Return Tradeoff

Hiranya Dissanayake
Lecture Outline
• How to measure Return
• How to measure Risk
• Risk Return Tradeoff
• Group Work
RETURN
What is Return?
• “Income received on an investment plus
any change in market price, usually
expressed as a percent of the beginning
market price of the investment “
What are the components of Return?
Components of Return
Components of Return
 Yield
• The most common form of return for investors is
the periodic cash flows (income) on the
investment, either interest from bonds or
dividends from stocks.
 Capital Gain
• The appreciation (or depreciation) in
the price of the asset, commonly
called the Capital Gain (Loss).
Example
• Amal purchased a stock for Rs. 6,000. At the end
of the year the stock is worth Rs. 7,500. Ali was
paid dividends of Rs. 260. Calculate the total return
received by Amal.
Expected Return
 The investor cannot be sure of the amount of return
he/she is going to receive.

 There can be many possibilities.


 Expected return is the weighted average of
possible returns, with the weights being the
probabilities of occurrence
Formula
• E ( R ) =  X* P(X)

• where X will represent the various values of


return, P(X) shows the probability of various return
Introduction
• Risk cannot be avoided.
• Everyday decisions involve financial and economic
risk.
– How much car insurance should I buy?
– Should I refinance my mortgage now or later?
• We must have the capacity to measure risk to
calculate a fair price for transferring risk.

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Defining Risk
• According to the dictionary, risk is “the possibility
of loss or injury.”
• For outcomes of financial and economic decisions,
we need a different definition.

Risk is a measure of uncertainty about the future


payoff to an investment, measured over some time
horizon and relative to a benchmark.

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Defining Risk
1. Risk is a measure that can be quantified.
– The riskier the investment, the less
desirable and the lower the price.
2. Risk arises from uncertainty about the future.
– We do not know which of many possible
outcomes will follow in the future.
3. Risk has to do with the future payoff of an
investment.
– We must imagine all the possible payoffs
and the likelihood of each.
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Defining Risk
4. Definition of risk refers to an investment or
group of investments.
– Investment described very broadly.
5. Risk must be measured over some time
horizon.
– In general, risk over shorter periods is
lower.
6. Risk must be measured relative to some
benchmark - not in isolation.
– A good benchmark is the performance of a
group of experienced investment advisors
or money managers.
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Measuring Risk
• We must become familiar with the mathematical
concepts useful in thinking about random events.
• In determining expected inflation or expected
return, we need to understand expected value.
– The investments return out of all possible
values.

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Possibilities, Probabilities, and Expected
Value
• Probability theory states that considering
uncertainty requires:
– Listing all the possible outcomes.
– Figuring out the chance of each one occurring.
• Probability is a measure of the likelihood that an
event will occur.
• It is always between zero and one.
• Can also be stated as frequencies.

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Possibilities, Probabilities, and Expected
Value
• We can construct a table of all outcomes and
probabilities for an event, like tossing a fair coin.

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Possibilities, Probabilities, and Expected
Value
• If constructed correctly, the values in the
probabilities column will sum to one.
• Assume instead we have an investment that
can rise or fall in value.
– $1000 stock which can rise to $1400 or fall
to $700.
– The amount you could get back is the
investment’s payoff.
– We can construct a similar table and
determine the investment’s expected value
- the average or most likely outcome.
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Possibilities, Probabilities, and Expected
Value

• Expected value is the mean - the sum of their probabilities


multiplied by their payoffs.

Expected Value = 1/2($700) + 1/2($1400) = $1050

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• Are you saving enough for retirement?
• You might be tempted to assume your investments
will grow at a certain rate, but understand that is
not the only possibility.
• You need to know what the possibilities are and
how likely each one is.
– Then you can assess whether your retirement
savings plan is risky or not.

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Possibilities, Probabilities, and Expected
Value
What if $1000 Investment could
1. Rise in value to $2000, with probability of 0.1
2. Rise in value to $1400, with probability of 0.4
3. Fall in value to $700, with probability of 0.4
4. Fall in value to $100, with probability of 0.1

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Possibilities, Probabilities, and Expected
Value

Expected Value =
0.1x($100) + 0.4x($700) + 0.4x($1400) +0.1x($2000) = $1050

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Possibilities, Probabilities, and Expected
Value
• Using percentages allows comparison of returns
regardless of the size of initial investment.
– The expected return in both cases is $50 on a
$1000 investment, or 5 percent.
• Are the two investments the same?
– No - the second investment has a wider range of
payoffs.
• Variability equals risk.

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Measures of Risk
• It seems intuitive that the wider the range of
outcomes, the greater the risk.
• A risk free asset is an investment whose future
value is knows with certainty and whose return is
the risk free rate of return.
– The payoff you receive is guaranteed and cannot
vary.
• Measuring the spread allows us to measure the
risk.

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Variance and Standard Deviation
• The variance is the average of the squared
deviations of the possible outcomes from their
expected value, weighted by their probabilities.
1. Compute expected value.
2. Subtract expected value from each of the
possible payoffs and square the result.
3. Multiply each result times the probability.
4. Add up the results.

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Variance and Standard Deviation
1. Compute the expected value:
($1400 x ½) + ($700 x ½) = $1050.

2. Subtract this from each of the possible payoffs and square the results:
$1400 – $1050 = ($350)2 = 122,500(dollars)2 and
$700 – $1050 = (–$350)2 =122,500(dollars)2

3. Multiply each result times its probability and add up the results:
½ [122,500(dollars)2] + ½ [122,500(dollars)2] =122,500(dollars)2
The Standard deviation is the square root of the variance:
= = 2 = $350
Variance 122,500dollars

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Variance and Standard Deviation
• The standard deviation is more useful because
it deals in normal units, not squared units (like
dollars-squared).
• We can calculate standard deviation into a
percentage of the initial investment, $1000, or
35 percent.
• We can compare other investments to this
one.
• Given a choice between two investments with
equal expected payoffs, most will choose the
one with the lower standard deviation.

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Measuring Risk: Case 2

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Variance and Standard Deviation
• The greater the standard deviation, the higher the
risk.
– Case one has a standard deviation of $350
– Case two has a standard deviation of $528
• Case one has lower risk.
• We can also see this graphically:

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Variance and Standard Deviation

• We can see Case 2 is more spread out - higher standard deviation.

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